Bank loans and overdrafts

All businesses need cash to operate – that’s pretty basic business. But there are quite a few ways that firms can raise finance apart from selling its goods or services.

The process of looking for money to start a new business is called raising finance. There are several ways an entrepreneur might choose to get their hands on some money. These will include: hire purchase and leasing, loans from family and friends, overdrafts, mortgages, bank loans, owners funds, selling shares and government grants.

So let’s take a look at some of these methods in a bit more detail!

A bank may lend money to a business if it thinks the idea is good, therefore meaning that it believes a business will be able to repay it. The bank will award a business a sum of money, known as a loan, which the business will then agree to pay back in several instalments over a number of years.

On top of these instalments, the bank will also charge interest on the loan, which is an extra payment made to the bank that allows it to make a profit from lending money. Interest rates can be high depending on the type of loan, so this source of finance can often be an expensive one for businesses, and can often get businesses into hot water!

Rates may also be high because banks often consider start up businesses to be high-risk owing to low customer levels – again making loans a risky business.

Just to add to the stress of a bank loan, banks can also ask for collateral.

Collateral is something that a bank can sell if a business doesn’t repay its loan from that bank. Banks can ask for collateral from a business before they make a decision to award them a loan. For example, if a sole trader fails to repay a bank loan, under the loan agreement, the bank may be able to take possession of and therefore sell the trader’s house.

Secondly a bank and a business can arrange to have an overdraft within a loan. Overdrafts are bank loans that are extremely flexible as businesses only use them if they need to. They enable businesses to borrow varying amounts of money within and up to an agreed limit with the bank.

For example, if a bank gave a business an overdraft of £1,000, during any point in the overdraft period the business may borrow any amount of money it likes up to £1,000. As a result, the business always has the option of borrowing this money, but only does so if it needs to. This may be because the business has peaks and troughs in terms of its annual profits, meaning that during the months when its profits are good, there is no need to use the overdraft, but during the months when its profits are low, the overdraft allows the business to keep going.

This also means that businesses will not constantly be paying interest on the loan. However, banks do not always agree to give overdrafts to businesses, and even if they do, the interest rate may be quite high, making it expensive like a conventional bank loan. Banks are also able to remove an overdraft facility without much notice, which can leave a business in severe financial difficulty.

Thirdly, a business can use a mortgage when looking to buy an area of land or a building. This is because a mortgage is a specific type of loan that is used to buy portions of land or buildings, such as shop or office space only.

They can be given to businesses by banks and building societies, and like a typical loan the business must pay the mortgage back in instalments until the money and any interest has been fully repaid. Mortgages are typically long-term loans which can last up to 30 years.

Furthermore, the sums of money involved in mortgages are typically very high as a result of land and buildings often being very expensive. Like a normal loan, banks can ask for collateral when giving a mortgage, which in this case is usually the land or building bought with the mortgage. Therefore if a business fails to repay the loan, the bank will take ownership of this land or building.

Finally if the pressure of having a bank loan is just too much to handle, or if you just can’t get accepted for a bank loan or mortgage, you can always turn to your family and friends!

Entrepreneurs will often turn to family and friends for financial assistance when starting a business, as such loans are easy to arrange, often interest-free, and the person giving the loan will often be more willing to do so than a bank.

However, disadvantages include the loaner being unable to lend the required amount or suddenly needing the money returned for their own expenses. A friend or family member is also less likely than a bank to check that the business idea is a good one and is likely to succeed.